Time to Step Aboard China’s Rail Investments

It’s too soon to know what caused July’s deadly high-speed rail accident in Wenzhou, but not too late to try making money from the conclusions. The government says its investigation of the collision of two bullet trains that killed 40 and injured 191 has concluded—though details about what happened aren’t yet ready for public consumption. Even so, train ridership is up, bullet trains are back on track after inspections and funding for the sector is flowing anew.

Now, two Citigroup Inc. analysts say it is time for investors to have a fresh look at one of the companies that equipped the trains – but wasn’t implicated – that collided in July. Shares of Hollysys Automation Technologies Ltd. are a “buy,” with more than 50% upside potential, says the new 52-page report focused on the company.

Analysts Paul Gong and Jenny N. Zhen said positives for Beijing-based Hollysys include its “secular growth potential in industrial automation amid rising labor costs,” “market-share gain opportunities from foreign players” and “a relatively good position in the railway market.”

Hollysys published its own conclusion two days after the accident, saying its signaling equipment on board both trains functioned well.

Its Nasdaq-listed stock nevertheless suffered, along with others in the rail sector that have been hit hard since the railway minister was fired in February.

Now, the Citigroup analysts say Hollysys shares could rise as far as $13.60 each, a 50%-plus gain from the $8.98 level the stock stood before the report’s publication early this week.

After the train crash, Hollysys was subject of a Wall Street Journal investigation that explained how China's use of foreign technology in its bullet-train signal systems highlighted deep international distrust over the country’s industrial model, including weak intellectual-property protections, which can complicate efforts to acquire state-of-the-art technology.

The story quoted people familiar with the situation as saying Hollysys obtained some signaling components from Japan’s Hitachi Ltd. Executives from Hitachi were quoted as saying they designed some systems sold to Hollysys with “black box” designs to prevent copying. A senior Hitachi executive said: "It's still generally a mystery how a company like Hollysys could integrate our equipment into a broader safety-signaling system without intimate knowledge of our know-how."

Hollysys declined to comment then. A spokeswoman couldn’t be reached on Wednesday. During a conference call with investors last month, Hollysys Chairman Wang Changli and another executive suggested that rail signaling business will take a back seat to the company’s other businesses. Their comments suggested the focus has shifted toward the company’s traditional but lower-profile, lower profit-margin factory automation business, where executives said projects happen more quickly than in rail and there are more potential clients.

“From an investor point of view, the more fundamental value comes more from the factory automation business than its rail business,” said Citigroup’s Mr. Gong. He said railway news has driven the stock price this year but its underlying business has been overlooked by investors.

Mr. Wang said in the Hollysys conference call China’s high-speed rail signaling business had “substantially slowed down,” noting that he looked forward to the government’s final report on Wenzhou, “so we can gain some visibility” about the sector.

"We are cautiously optimistic on continuous revenue generation from China’s high-speed rail segment for the next few years,” Mr. Wang said. He also said the company intends to export its rail equipment and become “one of the leading international signal players.”

Even so, it may become more difficult for investors to gauge how Hollysys does in high-speed rail because the company also said that effective with its fiscal first quarter of July, August and September, it had re-categorized how it books revenue in high-speed rail.

High-speed rail will be lumped together its subway-related business. Mr. Gong estimated its main high-speed signaling product represents about 10% of Hollysys revenue.